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North Korea to Denuclearize: Are Defense Stocks in Trouble?

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To everyone’s surprise the first-ever formal meeting between U.S. President Donald Trump and his North Korean counterpart Kim Jong-Un in Singapore was extremely successful. While the eco-political consequence of signing the denuclearization agreement at this historical meeting was a constructive one, hinting at a peace regime across the Korean peninsula, it does not bode well for the U.S. defense industry.

Major U.S. defense contractors paid the price, witnessing a sudden downfall in their stocks on Tuesday, since a settlement of the long-standing conflict between these two nations may lower demand for weaponries from these contractors.

Crux of the Denuclearization Deal

President Trump and Chairman Jong-Un signed an agreement at yesterday’s historical summit that aimed at averting any major military confrontation between the two nations, at least in the near term. The two primary aspects of the agreement were Kim’s renewed commitment to complete denuclearization of the Korean Peninsula and Trump’s promise to pull out thousands of troops stationed in South Korea.

While the minute details of the deal were not made public, in a press conference, Trump announced that as part of the deal America will end joint military drill with South Korea against North Korea and eventually withdraw troops from the Korean Peninsula.

Defense Stocks That Took a Beating

Frequent cross-border altercations between the United States and North Korea were one of the primary driving forces behind defense stocks’ rally last year. Indeed, major U.S. defense contractors, especially the ones that manufacture high-end missiles or offer missile surveillance services, hit all-time highs, following the countering missile-test war between these two nations.

Naturally, the signing of the denuclearization deal, hinting at easing of tensions between Pyongyang and Washington, sent the following defense stocks lower.

The company’s shares have lost 1.5% since the news of denuclearization surfaced.

Raytheon Company RTN is one of the largest aerospace and defense companies in the United States with a diversified line of military products, including missiles, radars, sensors, surveillance and reconnaissance equipment, communication and information systems, naval systems, air traffic control systems and technical services. Its notable missile system includes the Tomahawk cruise missile, an advanced surface or submarine-launched cruise missile with loitering and network communication capability. Raytheon currently carries a Zacks Rank #2 (Buy).

The company’s shares have lost 2.8% since the announcement.

Lockheed Martin LMT is the largest defense contractor in the world, which manufactures military aircraft, Joint Light Tactical vehicle, Littoral combat ships and many more alike defense equipment. Among its varied missile programs, notable ones are the Patriot Advanced Capability-3 (PAC-3) and Terminal High Altitude Area Defense (THAAD). Lockheed Martin currently carries a Zacks Rank #3 (Hold).

The company’s shares lost 1.3% in the last trading session.

General Dynamics GD is a prominent military shipbuilder and is one of the only two contractors in the world equipped to build nuclear-powered submarines. It manufactures combat-proven missile destroyer ships, missile submarines as well as tactical missile aerostructures. General Dynamics currently carries a Zacks Rank #3.

The company’s shares lost 1.6% following the announcement.

Will the Deal Really Jeopardize Defense Growth?

While the signing of the denuclearization deal has adversely impacted defense stocks, the effect will wane over time. After all, United States’ cross-border tension with North Korea was not the sole driver of U.S. defense stocks.

Factors like expansionary U.S. budgetary amendments under Trump administration along with rising defense spending by other major regional powers such as Japan and India have boosted investors’ optimism in the U.S. defense industry. Also, owing to regional tensions in the Middle East, U.S. defense majors have been increasingly receiving contracts from countries like Qatar, Saudi Arabia and Kuwait, which are boosting international sales. In fact, the aforementioned defense primes have been witnessing upward earnings estimate revisions even before the U.S-North Korea tension escalated, thanks to intrinsic strength of their diverse product portfolio.

Moreover, analysts are skeptical about the viability of the deal over the long term. This is because North Korea had made similar commitments in the past but continued to develop nuclear weapons. In fact, following the summit, Trump said that there is no surety that there will not be a reversal of situation in another six months or so, owing to which he may act against Jong-Un. This keeps the doors open for defense majors to regain momentum.

We believe signing of the deal is a small step toward maintaining peace between these two nations. Verification and monitoring will be necessary to ensure that North Korea has actually put down its nuclear weapons. For this, the U.S. government will have to rely on its defense contractors. So, all’s not lost for the U.S. defense majors.

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